Recent findings and observations by the International Monetary Fund (IMF) appear to indicate a weakening of the link between employment and inflation. One potential cause of the weakened relationship is the independence of central banks and their success at actively managing inflation in the recent past.

The success of such inflation management practices since the 1970s may have increased central bank credibility to such a degree that the labor market has become less responsive to inflation. The historical relationship is that higher unemployment decreases inflation because workers are willing to accept lower wages, and thus employers are able to reduce prices on their goods. But central banks’ success in stabilizing inflation may have changed the dynamic. In the recent global financial crisis, because workers could not count on prices dropping, they were unwilling to accept lower wages, thus making it difficult for employers to reduce prices.

An alternate view is that in the current recession, generous welfare packages have lured workers, whose skills are obsolete, from the labor force. As a result, fewer workers are competing for jobs, lessening downward pressure on wages.

Central bank behavior is a critical element in how an economy functions. The author sheds light on the current weak relationship between unemployment and inflation and attributes this relatively new, and perhaps temporary, paradigm to central bank policy in the rich nations of the world. Regardless of the reason, investors need to be aware that central banks may potentially require new mechanisms to replace or supplement the target inflation rate in order to manage economies. The historical relationship may also return, as inflation hawks argue, which could cause some disruption in the markets as investors scramble to readjust expectations.

The IMF’s observation of the weakened link between inflation and unemployment is compelling in that it suggests new mechanisms may emerge with which central banks can manage economies.